How useful are circuit breakers?
Because of the massive volatility in global equity markets
over the past fortnight, an interesting piece of news may have passed
relatively unnoticed - the apology by China's market regulator for its
"shortcomings" in the way it handled steep plunges in its stock
market.
Comments
R Sivanithy
27 January 2016
Because of the massive volatility in global equity markets over the past fortnight, an interesting piece of news may have passed relatively unnoticed - the apology by China's market regulator for its "shortcomings" in the way it handled steep plunges in its stock market.
"The abnormal fluctuations on the stock exchanges have revealed the immaturity of the Chinese markets...they also exposed shortcomings in the supervision, as well as regulatory mechanisms that are inappropriate and ineffective," said Xiao Gang, head of the China Securities Regulatory Commission, a little more than a week ago.
Although not explicitly stated, among the regulatory mechanisms referred to must have been the China market's circuit breakers which had been installed only a fortnight earlier - only to be hastily removed after just four trading days.
It might be useful at this juncture to recall the US Federal Reserve's position on the controversial practice of halting trading in instances when prices plunge and emotions are running high, bearing in mind that in theory, halts give the market time to draw breath and perhaps calm down, thus reducing volatility.
In a 1998 testimony to the US Senate Committee on Banking, Housing and Urban Affairs, Fed governor Susan Phillips said the Fed does not support halting trading when prices fall by predetermined, presumably large amounts.
"The board believes that markets should be allowed to remain open to ensure that equity portfolios can be valued reliably and that investors can adjust their holdings and thereby effectively manage their risks. The decision to close markets should neither be taken lightly nor be taken frequently. Indeed, the evidence is inconclusive at best as to whether circuit breakers are a useful feature of our markets."
Perhaps most relevantly from the viewpoint of those who think market jitters will be calmed by closing the market, she added: "It is an illusion to believe that investors' fears will be assuaged merely by closing markets. Such a closure could well have the opposite effect - it might increase investor concerns, causing them to dump shares at the next opportunity."
This "opposite effect" was precisely what occurred from Jan 4 to Jan 7 when China's circuit breakers were repeatedly triggered, prompting trading to be closed for the day on Jan 7 after only 30 minutes.
Faced with a barrage of criticism from participants who felt that the ramshackle circuit breakers were contributing nothing except intensifying selling pressure, regulators quickly lifted these mechanisms.
Academic studies also do not support artificial, exchange-imposed interventions. In "Volume, Volatility and New York Stock Exchange Trading Halts" in the March 1994 Journal of Finance, the writers found that trading halts did not reduce either volume or volatility but instead led to their increase.
"Volume (volatility) in the first full trading day after a trading halt is 230 per cent (50 to 115 per cent) higher than following 'pseudo-halts': non-halt control periods matched on time of day, duration, and absolute net-of-market returns. These results are robust over different halt types and news categories," said the authors.
Fortunately, the approach in Singapore is more calibrated, measured and, most importantly, directionally neutral, that is breakers here do not only kick in when stocks fall but also when they rise.
Also important is that trading is not stopped altogether; instead, if a counter rises or falls by 10 per cent, trading can still continue, though not beyond the 10 per cent limit for five minutes, a period short enough to be minimally intrusive yet deemed sufficiently long for the market to gather its thoughts and for information to be disseminated.